Difference Between LLC and Corporation: Everything You Need to Know
The difference between LLC and corporation is largely tax-related. 6 min read
Difference between LLC and Corporation
The difference between LLC and corporation is largely tax-related. Whether a legal entity is a tax entity, and the type of tax entity that it is, depends on how it is classified by the IRS and perhaps state and local tax authorities.
Legal entities, such as corporations and LLCs, can be different types of tax entities depending on how they are formed. For instance, a corporation is a legal entity that can be classified as either a C corporation or an S corporation tax entity depending on its articles of incorporation. LLCs have even greater flexibility when it comes to tax entity status.
Limited Liability Company (LLC) Set-up
One or more legal entities can form an LLC by filing Articles of Organization and an Operating Agreement with the state. Owners of an LLC are called “Members.”
Starting a Corporation
Corporations are only formed by filing Articles of Incorporation with the state. Each state has specific requirements that must be followed. Corporations also need to designate shareholders and a Board of Directors.
What is Incorporation?
Why is an LLC NOT a Corporation?
An LLC is a “Limited Liability Company” not a “Limited Liability Corporation.” An LLC is not incorporated; it is thus not a corporation.
LLC Taxes vs. Corporation Taxes
Members of LLCs have the ability to decide if they want the LLC to be taxed as its own legal entity, or if individual members will bear the tax burden instead. The traditional corporation, however, is always taxed on its own. Shareholders then suffer double-taxation when they pay taxes on dividends. This is known as a C corporation.
To avoid double-taxation, corporations can be designated as S corporations. S corporations are not taxed, but shareholders still need to pay taxes on dividends received. However, not all corporations qualify to be designated as S corporations. Certain corporations, in order to operate the way they are intended to operate, must be considered C corporations.
LLCs have much more freedom – no matter how an LLC is structured, its members can choose how it is to be taxed. By default, an LLC is not taxed. LLCs are called “pass-through” entities because the tax burden passes through the LLC and is applied directly to individual member incomes instead. LLC members can elect to have the LLC treated the same as a C corporation or S corporation instead.
LLC members pay self-employment tax on their income. Corporate shareholders who also work in the business are considered employees and pay tax on their employment income (including FICA taxes)
Another significant distinction between an LLC and an S corporation is that profits from an LLC are subject to employment taxes, whereas S corporation dividends are not. S corporations are also taxed at a corporate rate, whereas LLC members are taxed based on their Adjusted Gross Income.
Any legal entity in which profits and losses of the business pass through to the owners is a “pass-through” entity for tax purposes. LLCs, like partnerships, are pass-through entities by default. S corporations can also elect to be treated as pass-through entities in certain circumstances.
Corporations are owned by shareholders; LLCs are owned by members. LLCs have complete control over how ownership is distributed among the members. Some LLCs may make ownership percentages equal to the capital contribution each member has made; other LLCs may base ownership on skill or time contributions, and still, other LLCs may distribute ownership based on completely different metrics. There are no set rules to how LLC ownership should be determined.
Corporations, on the other hand, are owned in direct proportion to how many shares a person has. It is possible for corporations to create a unique stock class structure, but to do so, it must be considered a C corporation and subject to double-taxation.
Corporations are governed by a Board of Directors and corporate officers. Generally, a Board of Directors handles the broader management duties, and the officers take care of the day to day operations. Shareholders own a corporation but are typically not involved in the management of it. LLCs, meanwhile, can be managed directly by its members or have a separate group of managers. In some cases, LLCs have some members that have management responsibilities, and other “limited members” that merely have an ownership stake in the LLC.
There are several legal considerations to make when deciding between forming a corporation and an LLC. Corporations have existed since before the United States was formed, but LLCs were only first recognized in the 1970s. LLCs were designed to give owners more hands-on control over the company.
All states now recognize LLCs. In most ways, the laws governing LLCs are the same everywhere. However, there is nuance to each state’s law, and in a few ways, there could be significant differences from state to state. Therefore, before determining if an LLC is the right choice, anyone forming a company should consult with a business attorney that is familiar with the local laws.
Corporations Compared to LLCs
Both corporations and LLCs insulate owners from liability. Generally, LLCs are better for tax purposes because they can avoid the problem of double-taxation. Whether an LLC or corporation is better for any particular business depends on a number of factors. Savvy business owners often consult both a business attorney and an accountant before making a final determination.
Social Security Taxes for an LLC
Shareholders of S corporations are permitted to receive profits without paying Social Security taxes. Similarly, LLC members are not considered “employees,” and thus the LLC does not need to pay Social Security taxes.
Raising Money for an LLC
Corporate stock is usually easier to sell than membership interests in an LLC. Therefore, if you are planning on selling or expanding ownership of an entity, the corporate form may make that easier.
Liability Protection for an LLC
Typically, both LLCs and corporations protect owners from liabilities by what is known as the “corporate veil.” However, in many states, shareholder dividends can be seized when a corporation has liabilities.
Profits, Losses, and Taxes for an LLC
LLCs have more flexibility in how they make allocations of profits and losses among members than corporations have. Corporations allocate profits and losses strictly according to the percentage ownership.
The money and property members contribute to an LLC is not taxable. In a corporation, only contributors who have a controlling interest (i.e., a majority of voting shares) can contribute tax-free.
Foreign Ownership for an LLC
An LLC can be owned by any legal entities, including foreign individuals or foreign corporations or trusts. S corporations can only be owned by individuals, and cannot be owned by foreigners (although resident aliens can be shareholders).
LLCs can have an unlimited number of members. S corporations cannot have more than one hundred shareholders.
Management Options for an LLC
There are few formalities constraining how LLCs are to be managed. LLCs can be member-managed, managed by officers, or any combination thereof.
Fringe Benefits of Corporations and LLC
Corporations offer the greatest variety of fringe benefits. Shareholders can enjoy retirement plans, stock options, and employee stock purchase plans. An often overlooked benefit of a C corporation is that shareholder-employees do not need to pay taxes on benefits, whereas LLC members or employees that own more than 2 percent of an S corporation pay taxes on benefits.
Who Can Help Me Make This Decision about Forming an LLC?
Choosing the correct business entity is important. Many business owners consult with both a business attorney and a certified public accountant before making their decision. A business attorney can help you understand legal risks and make a decision that fits your business model, while a CPA can explain the tax differences to help you make the best choice financially.
LLC vs. Corporation: What’s the Real Story?
Your choice of entity should be well thought out. The best choice can get your business started off on the right foot, give your company stability in the future, and maximize your personal return. Think about both your short-term and long-term goals, and prioritize the latter if you can afford to.
Dividends and Venture Capitalists
C corporations are sometimes the preferred choice for growing businesses because they provide for easier ownership investment through stock.
C Corporation Earnings
Another benefit of C corporations is that they can accumulate and hold-over a certain amount of earnings from year-to-year.
Ability to Leave Money in the Company
Although C corporations are subject to double taxation, they do offer more flexibility when it comes to shifting income around within the business compared to LLCs and S corporations. If you own a C corporation as the majority shareholder and pay yourself a salary as an employee, to a large extent, you have complete freedom to decide how much of the corporate profits to leave in the business and how much to take out for yourself.
Ability to Deduct a Loss
A benefit of LLCs and S corporations is that LLC members and S corporation shareholders are able to deduct the business’ operating losses on their personal income tax return if they want to. C corporation shareholders cannot deduct these losses.
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